Accretion vs. amortization
Also known as: accretion of discount, amortization of premium
Accretion and amortization are opposite cost basis adjustments for bonds. Accretion gradually increases the cost basis of a bond bought at a discount, while amortization gradually decreases the cost basis of a bond bought at a premium, moving both toward par by maturity.
Accretion and amortization are the two ways a bond's cost basis is adjusted over its life. When an investor buys a bond at a discount (below par), accretion increases the cost basis each year until it reaches par at maturity. When an investor buys a bond at a premium (above par), amortization decreases the cost basis each year until it reaches par at maturity. Either way, the bond's adjusted basis converges on its $1,000 par value.
The straight-line method makes the math simple. Suppose an investor buys a bond at $950 with 10 years to maturity. The $50 discount is accreted at $5 per year, so after four years the adjusted cost basis is $970. A bond bought at $1,050 with 10 years remaining is amortized at $5 per year, so after four years its basis is $1,030.
These adjustments matter for taxes. Accreted discount on a taxable original issue discount (OID) bond is reported as taxable interest income each year — often called phantom income, since the investor receives no cash — while accretion on a municipal OID bond is tax-exempt interest. Amortized premium reduces the bondholder's reported interest income on taxable bonds and must be amortized on tax-exempt municipal bonds. Because the basis is adjusted annually, a bond held to maturity typically produces no capital gain or loss.
Accretion and amortization show up regularly on the Series 7 exam, which expects you to calculate an adjusted cost basis, determine the gain or loss on a bond sold before maturity, and know how the rules differ for corporate, municipal, and OID bonds.
Key takeaways
- Accretion adjusts a discount bond's cost basis upward toward par; amortization adjusts a premium bond's cost basis downward toward par.
- Under the straight-line method, the discount or premium is divided evenly across the years to maturity.
- Accreted discount on a taxable OID bond is taxed annually as interest income even though no cash is received.
- A bond held to maturity usually has no capital gain or loss because its adjusted basis equals par.
- The Series 7 exam tests adjusted cost basis calculations and the resulting gain or loss when bonds are sold early.